Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2017. The project is a required component of every master program.
We present a tradeoﬀ model of capital structure to investigate the sources of adjustment costs and study how ﬁrms’ ﬁnancing decisions determine partial adjustment toward target leverage ratios. The presence of market imperfections, like taxes and collateral constraints, is shown to play a decisive role in the behavior of the policy function of capital and leverage. By means of a contraction argument, we are able to show the existence of a target leverage towards which optimal leverage converges with a speed of adjustment that depends on a ﬁrm marginal productivity of capital. Our predictions are consistent with the empirical literature regarding both the magnitude of the speed of adjustment and the relationship between leverage ratios and the business cycle.
In this work we showed how ﬁnancial and economic frictions are able to generate a partial adjustment dynamics in leverage policy functions. In the model we studied, the key factors of this phenomenon are collateral constraints (which strike a balance between tax beneﬁts of debt and distress costs) and ﬁrm productivity of capital. The latter, in particular, determines the speed of adjustment towards the (state-dependent) target leverage ratio.
Our model ﬁts well several stylized facts of leverage dynamics established by the empirical literature: an example is given by the magnitude of the speed of adjustment, which falls into the conﬁdence intervals estimated by several authors. Another one, is the countercyclical behavior of leverage dynamics with respect to the business cycle, which is due to the fact that in recessions it is easier for the collateral constraint to be binding.
Future work should ﬁrst address the translation of the hypotheses of Theorem 5.4 on the Lagrange multiplier into assumptions on the components of the model (the production function and the various market frictions). The next step would then be to extend the model to a full general equilibrium model to study thoroughly the eﬀects of preference and monetary shocks on leverage dynamics. Pairing consumers’ utility maximization with ﬁrms’ ﬁnancing problem would also allow to study the interaction between expected returns and partial adjustment: in such framework, the collateral constraint should probably be replaced by several credit rating inequalities determining both ﬁrm speciﬁc discount rates and target leverage ratios.